Fund Managers’ Profits Are Ripe for a New Tax

David M. Halbfinger|The New York Times

Wednesday, 30 Jun 2010 | 8:06 AM ETThe New York Times

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Finally, NY Gov. David A. Paterson and legislative leaders have found something they can agree on: that hedge fund managers from Connecticut and New Jersey should pay the state of New York millions more in taxes.

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NY Governor David Paterson

As they grapple with a gaping budget shortfall, Mr. Paterson and the lawmakers plan to enact a tax change that will treat much of the compensation earned by the fund managers who work in New York but live outside the state as ordinary income.

Many fund managers are paid a flat management fee of 2 percent of assets, plus — as a performance incentive — as much as 20 percent of any profits they generate. The latter amount, known as “carried interest” or “the carry,” has been taxed federally at a rate of 15 percent because it is treated as a capital gain, rather than as ordinary income, which is subject to rates as high as 35 percent.

Democratic leaders in Congress have tried three times so far this year to reclassify that compensation as ordinary income. They have failed each time.

In New York, by contrast, lawmakers over the weekend embraced a proposal by Mr. Paterson to begin taxing nonresident fund managers’ carried interest.

Budget officials in Albany hope to reap about $50 million a year from the change.

But tax lawyers and representatives of investment firms argue that the fund managers could wind up being taxed twice on the same earnings, and warn that those who already live in places like Greenwich, Conn., or Summit, N.J., could decide to move their businesses out of New York altogether and work closer to home.

“It could be one more reason to move,” said Richard S. Zarin, a tax lawyer at the firm Morgan, Lewis who represents a number of investment fund organizers. “Having my office in New York versus Greenwich is now costing the partners who live in Connecticut more money than it used to.”

Under existing state laws, people are generally taxed on their income by the states where they work and on their investment gains by the states where they live. Because carried interest has been treated as investment income, and in New York State is subject to the same tax rate as other income like salary and wages, fund managers who live in the state have already been paying state tax on it.

But the carried interest earned by an estimated 1,000 New York fund managers living in Connecticut or New Jersey has been taxed only by their home states, officials said. (For people earning more than $500,000, the income-tax rate in Connecticut is 6.5 percent; in New York and New Jersey, 8.97 percent.)

By reclassifying carried interest as, essentially, payment for services, New York is seeking to tax nonresident fund managers as if their carried interest is no different from any other kind of fee paid for work performed.

But if Connecticut and New Jersey do not follow New York’s lead in reclassifying carried interest as ordinary income, those fund managers who continue to commute to work in New York could be taxed by two states on the same profits, tax experts said.

“You’ve got this potential for double taxation,” said Edouard S. Markson, a tax lawyer at Chadbourne & Parke with fund-manager clients. “Someone with enough money at stake is likely to bring a federal court challenge.”

Mr. Zarin, of Morgan, Lewis, also raised the question of whether foreign sovereign wealth funds or the pension plans of other states, which often help fund managers start new investment vehicles in return for a share of carried interest, could wind up having to pay state tax in New York. “Those people would never expect to have that happen,” he said.

But he said a more likely effect, at least for investment funds with small outposts in New York, would be “to say, ‘Do we really need that office in New York?’ You’d probably say, ‘I’d rather not have the headache.’ ”